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With the election over, it is time to get back to the economic mess. Many of you have been following my many essays on the repeal of Glass-Steagall and it consequences for the current financial crisis as well as the weakness of one of the worst pieces of legislation ever passed by Congress, the bailout bill.
One nice result of this election will be that Phil Gramm is out of the picture as an economic advisor, which should make us all feel a little safer about our money. But Gramm still left behind the mess we have. One of the pieces that has been little noticed but suddenly has come to the fore is a huge loophole in Gramm-Leach-Bliley which also has become an even bigger loophole in the current bailout attempt. That loophole is a little-noticed provision relating to ILCs, or Industrial Loan Corporations.
What Are ILCs
ILCs have actually been around for a long time. ILC’s are strange financial creatures in that they may be owned by nonfinancial institutions such as General Motors, but their biggest difference with regular banks is that they are state-chartered and not subject to federal regulation. The Federal Deposit Insurance Corporation fact sheet on ILCs gives a succinct definition:
Industrial loan companies and industrial banks (collectively, ILCs) are FDIC-supervised financial institutions whose distinct features include the fact that they can be owned by commercial firms that are not regulated by a federal banking agency.
This sentence describes the two unique features of ILC’s, features that currently have financial experts questioning the bailout legislation. These are that ILC’s can be owned by commercial firms (the GMAC loan company is an ILC) and that last kicker “not regulated by a federal banking agency.”
The FDIC fact sheet goes on to explain the consequences of the latter:
The ILC is subject to oversight by federal and state bank regulators; however, the controlling company in many cases is not.
A useful chart in the fact sheet points out the consequences of not being able to regulate the controlling company by outlining the differences between banks and ILCs. Among them is the fact that the “parent” of an ILC is not subject to the following:
Parent** subject to umbrella federal oversight; Parent** activities generally limited to banking and financial activities; Parent** could be prohibited from commencing new activities if a subsidiary depository institution has a CRA rating that falls below satisfactory; Parent** could be ordered by a federal banking agency to divest of a depository institution subsidiary if the subsidiary becomes less than well capitalized.
A Brief ILC History
ILCs were the brainchild of one Arthur Morris, a visionary who was concerned that middle income and poor people had trouble getting loans. The way Morris got around the banking laws at the time was to issue certificates in the value of the loan which the borrower then “purchased” in the amount needed. Morris’ other revolution was that the purchase of these certificates required no collateral, but only two cosigners who could vouch for the person purchasing the certificates.
Ever since, ILCs have also been known as Morris Plan banks. Under the well-meaning supervision of someone like Morris, ILCs performed a valuable function, but as the FDIC points out, they were totally unregulated since no one knew quite what to do about Morris’ unique approach to loans.
In the beginning, these entities were not subject to supervision by any federal banking regulator but rather were state-chartered and supervised by the states. These early industrials operated more or less like finance companies, providing loans (at a high interest rate) to wage earners who could not otherwise obtain credit. The loans were not collateralized but were based on endorsements from two creditworthy individuals who knew the borrower.
This state chartering of ILCs persists today.
In 1982, the federal government extended FDIC protection to Morris’ certificates.
Provisions of this legislation allowed ILCs that were regulated in a manner similar to commercial banks to apply for federal deposit insurance. Reinforcing this development, some states changed their laws to require their ILCs to obtain FDIC insurance as a condition of keeping their charters.
The entry of the FDIC into ILC’s allowed them to dictate the terms of the insurance, which included:
The financial history and condition of the applicant; the adequacy of the applicant’s capital structure, future earnings prospects, and character of management; the convenience and needs of the community.
The ILC Exception
The special status of an ILC was further defined in the repeal of Glass-Steagall. When Congress abolished Glass-Steagall in 1999, it left a huge loophole for ILCs by not making them subject to the Bank Holding Company Act, which regulates the activities of what we today term “full-service banks.” In 2007 testimony before the House Committee on Financial Services, Federal Reserve Vice Chairman Donald Kohn outlined the consequences of the loophole:
The ILC exception also creates an unlevel competitive playing field by allowing both financial and commercial firms to own an insured bank but avoid the prudential limitations, supervisory framework and restrictions on affiliations that apply to corporate owners of other insured banks.
Through the ILC loophole have poured a veritable cascade of new financial institutions. Kohn described what has occurred because of the loophole:
What was once an exception with limited and local reach has now become the avenue through which large national and international financial and commercial firms have acquired a federally insured bank and gained access to the federal safety net. Indeed, dramatic changes have occurred with ILCs in recent years that have made ILCs virtually indistinguishable from other commercial banks.
Kohn went on the cite statistics illustrating the growth of ILCs:
As a result of these and other changes, the aggregate amount of assets and deposits held by all ILCs operating under this exception increased substantially just in the nine years between 1997 and 2006, with assets increasing by more than 750 percent (from $25.1 billion to $212.8 billion) and deposits increasing by more than 1000 percent (from $11.7 billion to $146.7 billion). In fact, in 2006 alone, the assets and deposits of ILCs increased by $62.7 billion and $38.8 billion, respectively. The number of Utah-chartered ILCs also has doubled since 1997, while declining in the few other states permitted to charter exempt ILCs.
The nature and size of individual ILCs and their parent companies also has changed dramatically in recent years. While the largest ILC in 1987 had assets of approximately $410 million, the largest ILC today has more than $67 billion in assets and more than $54 billion in deposits, making it among the twenty largest insured banks in the United States in terms of deposits.
The Wal-Mart Fiasco
ILCs first came to the attention of the general public when Wal-Mart proposed to create its own ILC. In essence, the nation’s largest retailer would now become one of the nation’s largest banks. This is probably the place to point out that ILCs are not inherently evil. For many companies they perform a useful role. For example, when you buy a new car, GMAC will oversee your car loan if you don’t want to go to a bank.
Unfortunately, Wal-Mart proposed a far-reaching, fukk-service ILC that had organizations such as the American Bankers Association crying “foul,” for they charged that it would breach the long-sacred separation of banking and commerce. The ABA and others also feared Wal-Mart’s application would drive small town banks out of existence just as they have impacted other small town businesses. These reasons plus Wal-Mart’s economic clout aroused enough opposition that Wal-Mart withdrew its application in 2007.
Others Play the ILC Game
While a great deal of publicity has been generated by corporations such as Wal-Mart creating ILCs, less recognized has been the use of ILCs by banks themselves. The largest ILC is owned by Merrill Lynch, whose assets of $67 million make it among the top twenty financial institutions in the country. Goldman Sachs and Morgan Stanley also own ILCs, although both of them are in the process of converting them to bank holding companies.
But given the involvement of financial institutions in ILCs and the ILC loophole one has to ask whether any of the funds Paulson plans to invest could end up in ILCs, where they would be subject to less scrutiny.
The ILC Bailout Scandal
Well, it turns out banks began to use their bailout money for exactly what many feared, mergers and acquisitions, especially of ILCs. The biggest and most controversial of these deals was the acquisition of National City Corp. by PNC Financial Services Group. National City is an ILC. The PNC purchase caused Rep. Steve LaTourette to charge Comptroller of the Currency John C. Dugan steered bailout money to PNC because he was a former PNC attorney. LaTourette wrote Treasury Secretary Paulson question whether Dugan:
Steered $7.7 billion of taxpayer bailout money to his former client, PNC, so it could buy National City Bank
Dugan angrily denied the charge:
The suggestion is absolutely baseless, and I am astonished that you would make such sweeping allegations without checking the facts.
But the damage was done. A bank had used bailout money to buy an ILC.
In another blatant in-your-face move Cleveland’s KeyCorp, went so far as to say it plans to buy other banks. Key Chairman and Chief Executive Henry Meyer told the Cleveland Plain Dealer:
Meyer said he has three things in mind for the $2.5 billion his company is getting from TARP, the Troubled Asset Recovery Program: Strengthening Key’s finances, lending more and buying other banks.
Huntington Bancshares of Columbus also plans to use its bailout money to buy banks. Chairman and Chief Executive Thomas Hoaglin said in a written statement.
The capital allows us to give consideration to any strategic opportunities that may arise to expand our franchise through the purchase of weaker banks.
Those purchases will most likely involve ILCs. Banking analyst Jeff Davis of Wolf River Capital in Nashville said:
We’re going to see a lot of this TARP money used in the way PNC did with National City.
Why Would a Bank Want an ILC?
Now we get to the heart of the matter, why would a regular bank want to own an ILC? The answer lies in the loophole. By setting up a separate ILC, the bank can avoid Federal Reserve regulation. They can engage in whatever questionable practices they want without having the Fed looking over their shoulders. Laura Mandaro puts it well:
An industrial loan charter grants companies most of the powers bestowed by a commercial bank charter, including the ability to accept federally insured deposits and make consumer loans. Its main restriction is a prohibition on accepting demand deposits if the corporation has assets of more than $100 million. But with the restriction comes a big benefit: The charter holder does not need to follow the Bank Holding Company Act and thus avoids supervision by the Federal Reserve Banks.
So what we have are two loopholes coming together. The Gramm-Leach-Bliley loophole exempting ILCs from Federal Reserve supervision and the second worst financial bill is recent history, the so-called bailout bill, which did not even have the intelligence and foresight to forbid banks receiving bailout money from buying up ILCs.
Your Tax Dollars at Work
So while all of us sweat out the current financial crisis, our brilliant Congress left a loophole in the bailout bill wide enough to drive a truck through–a truck full of money on its way to purchasing an ILC. And what are they doing this with–your tax dollars. So the bottom line is that your taxes are being spent on two loopholes that never should have been there in the first place.
The fear is that if banks like PNC start squirreling away their bailout money in ILCs, it will be difficult to regulate it. In short, the bailout is a sham for it allows banks to get involved once again in the very activities that caused this crisis.
Let us hope that one item at the top of the new administration’s list is closing those loopholes as a first step to solving the financial mess we are in. It’s time to level the playing field and get ILCs under federal supervision.
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